GST hike will bring structural issue with law into sharper focus

A Court of Appeal finding late last year that a director breached his director’s duty by selling an asset in a failing business when he knew that the company would be unable to meet the ensuing GST obligation has since filtered through into IRD practice.

It is important, therefore, that directors are fully alert to the decision’s implications. This is particularly so as the monies involved in GST cases will become relatively larger after 1 October this year when GST rises to 15%.

Brief refresher on the case

Peace and Glory Society Ltd v Samsa concerned a property development company of which a Mr Stefano Samsa was sole director. Mr Samsa had bought a Northcote property with the intention of subdividing the land, renovating and selling the existing dwelling and using the proceeds from that sale to build a new house which he would also sell. But things did not go according to plan and, with the company insolvent, he bought the partly-renovated house himself in order to pay off his secured creditors, one of whom was his mother.

His rationale was that this would yield the best commercial result for his creditors. Unfinished and barely habitable, the house would not achieve a good price on the open market and the avoidance of real estate fees would put the company in a better position to meet its obligations. Mr Samsa was aware that he owed GST and offered the IRD $30,000 (this being all he could scrape together) in full and final settlement. IRD declined the offer and placed Peace and Glory in liquidation for unpaid GST debt of over $46,000 plus late payment penalties and interest.

The liquidators went to the High Court seeking an order for Mr Samsa to pay the debt on the basis that he had breached various directors’ duties under the Companies Act 1993 (the Act). The High Court rejected their claim in its entirety. They then went to the Court of Appeal where they also sought a damages award against Mr Samsa, but this time on the narrower grounds that he was in breach of section 136 of the Act. This provides that:

“A director of a company must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so”.

Where such a breach has been found, the Court may under section 301 of the Act order the director “to contribute such sum to the assets of the company by way of compensation as the Court thinks just”.

The Court was easily persuaded that Mr Samsa had breached his duty under section 136 by selling the property when he could have no reasonable basis for believing that the GST could be paid.

But the Court did not award damages against him. Mitigating factors the Court took into account were the “dilemma” confronting Mr Samsa in relation to the property’s saleability, the “genuine effort” he made to settle with the IRD and the fact that he “did not deliberately choose a course designed to disadvantage the IRD”.

Issues for directors

Although the Court of Appeal did not choose to exercise its powers under section 301 in this instance, the finding of a breach of duty should concern all directors of companies facing potential insolvency.

The effect of the ruling is to set up a conflict between the interests of the director and those of the company and, by implication, the company’s creditors and shareholders.

Whereas the best course for the company may be to sell encumbered assets with a view to reducing debt, the safest course for the directors – where there is a risk of not being able to meet GST payments – is to either:

ask the shareholders to put the company into liquidation (in which event, the liquidator would probably also sell the assets, and not necessarily for as good a return), or

ask the mortgagee to sell the assets.

None of which would create a problem if the priority enjoyed by different groups of creditors was the same regardless of who conducted the sale and when - but it is not.

Under the Goods and Services Act 1985, the IRD effectively ranks behind unsecured creditors if a mortgagor completes a sale before liquidation. But a sale by a liquidator or mortgagee, results in a personal GST liability of the (solvent) liquidator or mortgagee, thus ensuring that the IRD recovers the debt.

The difference in effective GST priority appears to have been the motivation for the Peace and Glory litigation. Certainly we are aware of the IRD relying on this case in similar circumstances when dealing with directors of insolvent companies.

The fact that GST is effectively afforded a higher rank in a sale by a liquidator or a mortgagee could ultimately drive a director to make a decision which is commercially undesirable from the company’s perspective and, as the Court noted, “could conceivably create a reluctance on the part of secured creditors to undertake enforcement steps and may impede a liquidation”.

“[T]hese consequences appear to us to be an issue with the design of the system where the nature of the priority for the debt depends upon who sells,” the Court said.

Solutions

The tensions are the product of an awkward interface between the GST Act on the one hand and the Companies Act on the other. This is a matter for the law-makers and not for this Brief Counsel but potential solutions would be:

to amend the GST Act so that entry into an insolvency process will have no effect on the relative positions of different creditors, or

to amend section 136 of the Companies Act to make it clear that it is intended to apply to primary obligations (e.g. incurring a liability to pay the purchase price of an asset), rather than tax which is a derivative liability arising as a result of something else the director has agreed to.

Practical advice for the here and now

Unless or until Parliament changes the law to deal with this conflict, a director of a distressed company needs to consider very carefully the company’s position and solvency when dealing with its assets.

The director needs to be aware that, while selling the assets to meet the company’s obligations may be the best commercial decision, an unsatisfied tax liability arising as a result of a sale could support an action for breach of directors’ duties. This may also extend beyond GST to include income tax, or indeed any obligation that arises because of the transaction.

Depending on the situation, it may be prudent for a director to:

put the company into liquidation or voluntary administration

ask the mortgagee to sell the company’s assets

vote against any action by a company which could give rise to additional tax if it is unlikely that the company will have the funds to meet that tax liability, or

in extreme circumstances, resign as a director.

If you are the director of a mortgagor company and the mortgagee is asking the mortgagor to sell an asset so as to ‘trump’ the IRD’s claim for GST, you should be aware that by cooperating with the mortgagee, you may be in breach of your directors’ duties and could be liable for damages.

If you are an insolvency practitioner, you should consider whether any claim based on a breach of s136 in these circumstances will lead to a damages award. If the overall financial position of the company was not worsened, was any loss suffered?

Our thanks to Jess Cameron for writing this Brief Counsel. For more information, please contact the lawyers featured.